THE PUZZLE OF WHO IS A 'CONTRACTOR'

How a simpler definition got lost in the budget deal

Since 1978, Congress has struggled unsuccessfully to answer what sounds like a simple question: What is the legal distinction between an employee and an independent contractor? The confusion has come at a steep price, especially for small companies. In the past eight years alone, they've been the target of more than 13,000 audits by the Internal Revenue Service, which has converted 527,000 ''contractors'' into employees--and levied more than $830 million in back taxes and penalties.

Last month, a legislative solution came within a whisker of passing. But it foundered after labor groups complained that it would foster a two-tier workforce, the Administration sympathized with those concerns, and Republican advocates showed no interest in compromising. For the full story of squandered opportunity, read on.

LONG TEST. As anyone who is running a small business knows, the decision to classify someone as an independent contractor derives from a ''20-factor test'' that the IRS created by distilling hundreds of court rulings. It considers factors such as whether workers provide their own equipment or take a financial risk in their work. But, as the audit figures show, that test still leaves plenty of room for interpretation.

When the GOP took over Congress in 1995, Representative Jon Christensen (R-Neb.) and Senate Small Business Committee Chairman Christopher S. Bond (R-Mo.), attempted to rectify the situation with a simpler, three-factor version (table). That plan didn't make much headway until this year's budget deal, when Christensen attached it to the House's tax-cut bill.

For procedural reasons, the Senate left the measure out of its tax bill. And Bond decided to concentrate on items that had a better chance of passing. But that removed Bond, who had drafted a new proposal to meet some labor objections, as a moderating force. To prove that contractors enjoy economic independence, Christensen would merely have required the company to show that its workers had invested in their own training. The AFL-CIO argued that, under that standard, any worker with a college education could be converted from employee to contractor. Bond's latest proposal, by contrast, would have imposed three conditions--including the contractor's opportunity to take profits or losses--to prove economic independence. ''Bond's bill would have undercut most of labor's objections,'' says James Morrison, a lobbyist for the National Association for the Self-Employed.

But the House stuck with Christensen's tougher version--and that gave labor its opening. While congressional tax experts figured about 1 million employees would become contractors under the bill, the Treasury Dept. estimated that more than twice as many could be forced to shift. And while advocates insisted that most new contractors would be professionals enjoying the freedom of self-employment, the AFL-CIO maintained that legions of low-skilled workers would lose their benefits.

Labor raised another issue: Employees enjoy more protection than contractors under a host of laws, from minimum-wage and overtime rules to bans on racial discrimination. The AFL-CIO argued that easier standards would undercut labor-law enforcement. That concern weighed heavily on Clinton's Treasury. ''Business has to realize that we can't separate the tax question from labor issues,'' says a senior Treasury official.

A SWAMP? In the budget talks, Clinton aides named killing the contractor rule as one of their top priorities. ''President Clinton had a choice of helping small-business America or satisfying the labor unions,'' declares Christensen. ''And the AFL-CIO won.'' GOP leaders, sensing a good bargaining chip, kept the contractor proposal alive until the budget talks' last round, when they used it to help win lower tax rates on capital gains.

The outcome leaves small business in the same swamp as before. Even the AFL-CIO agrees that worker-classification rules need to be clarified--and says it's willing to compromise. That may be distasteful to small-business advocates. But as long as labor has the ear of the President, negotiation may be the only hope.